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Financial Expertise as an Arms Race





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    • Glode is from the Wharton School, University of Pennsylvania. Green is from the Tepper School of Business, Carnegie Mellon University. Lowery is from the McCombs School of Business, University of Texas at Austin. We are especially thankful to Bruce Carlin and Bilge Yilmaz for suggestions that led to major improvements in the paper over earlier versions. We also thank two anonymous referees; Andy Abel; Philip Bond; Josh Coval; Limor Golan; Itay Goldstein; Brett Green; Isa Hafalir; Cam Harvey (Editor); Mark Jenkins; Ari Kang; Rich Kihlstrom; Doron Levit; Mark Lowenstein; Thomas Philippon; Joel Shapiro; Tri Vi Dang; and Lucy White; seminar participants at American University, Carnegie Mellon University, Cornell University, the Federal Reserve Board of Governors, Louisiana State University, the SEC, Southern Methodist University, University of Southern California, University of Texas-Austin, University of Colorado–Boulder, Vanderbilt University, the Wharton School, and the University of Wisconsin-Madison; and participants in the 2011 AEA meetings, the FDIC 2009 Bank Research Conference, the Fall 2009 Theory Workshop on Corporate Finance and Financial Markets at MIT, the 2010 FIRS Conference, the 2010 Corporate Finance Conference at Minnesota, the 2010 Financial Stability Conference at Tilburg, the 2010 UBC Summer Finance Conference, the 2011 WFA meetings, and the 2010 World Congress of the Econometric Society for their helpful suggestions and comments on the paper.


We show that firms intermediating trade have incentives to overinvest in financial expertise. In our model, expertise improves firms’ ability to estimate value when trading a security. Expertise creates asymmetric information, which, under normal circumstances, works to the advantage of the expert as it deters opportunistic bargaining by counterparties. This advantage is neutralized in equilibrium, however, by offsetting investments by competitors. Moreover, when volatility rises the adverse selection created by expertise triggers breakdowns in liquidity, destroying gains to trade and thus the benefits that firms hope to gain through high levels of expertise.

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